David Casper : Northwestern Mutual - Economic Commentary - November 2009 : Article: Economic Commentary

Economic Commentary - November 2009

Christopher Bremer

Senior Investment Consultant

Reports of the Collapse of the Dollar Have Been Greatly Exaggerated

Since March of this year the dollar has steadily declined against most major currencies. Through September, it has dropped about 15% versus a broad basket of world currencies. (Fig. 1.) The dollar’s decline has been precipitated by a reversal in the flight-to-quality trade that occurred in the second half of 2008 through the first quarter of 2009.

Investors fearing deflationary forces and the potential for a systemic collapse of the financial system sought the perceived safe haven of the Greenback. A year ago at the end of October, the dollar reached a two and a half year high against the euro, as investors fled to the safety of U.S.

government bonds in the aftermath of the Lehman Brothers failure. At the time, investors were not preoccupied with a too rapid ascent of the dollar. Instead, investors were left wondering which bank might fail next. As the global markets panicked, the dollar benefited.

A crack in the demand for dollars, however, tends to cause more intense and emotional

responses. In part, fear mongering is good for headlines. There is also a common, sometimes misplaced, perception that a strong dollar at all times is beneficial, even essential, for U.S. economic strength.

And now the recent dollar slide has garnered a lot of attention. And, while manufacturers are finding that their goods are more competitive in the global arena as a result of a weaker dollar and investors are attracted to borrowing at near-zero and investing in higher yield instruments, many are concerned that a dollar collapse is eminent. The fact is the dollar’s decline is occurring simultaneously with optimism that the global economic recovery has gained momentum.

Through Oct. 16, the U.S. Trade Weighted Major Currency Dollar fell 8.6% over the one year (52 week) period, right on the outer band of a ‘normal’ outcome (defined statistically as a range from -1 standard deviation to +1 standard deviation, reflecting an approximate 66% of all outcomes). (Fig. 2.) During the equity market lows of March 9, the Dollar had appreciated 20% over the one year period, representing a statistically significant event (+2.7 standard deviations for those statistically inclined). In other words, from a price movement perspective, the flight to the dollar during the global market dislocation period of July 2008 to March 2009 was significantly more meaningful than the dollar’s decline from March 2009 to October 2009.

Now, with signs that the global economy is healing and increasing concerns that accommodative monetary policy combined with mounting U.S. budget deficits will lead to inflationary pressures and a weaker dollar, investors are diverting more dollars into foreign currencies. Near term, this should not be entirely unexpected as investors’ appetite for riskier assets such as global equities and commodities has increased amid signs of improved global economic growth and buoyant equity markets around the world. In fact, through the first three quarters of 2009 the dollar’s decline has been fairly orderly. The stock market has embraced the weaker dollar as exporters and multinational companies have benefited from increased sales and currency translation gains. Longer term, critics argue that a weak dollar could shake the confidence of foreign borrowers who are critical in buying our debt.

The mechanics of exchange rate determination

On a global and local basis, changes in exchange rates can have a material impact on the allocation of resources, economic production, employment and ultimately a country’s standard of living. So, it makes sense to understand how exchange rates are set. Exchange rates are determined by the market interaction of supply and demand for specific currencies. The decisions to buy or sell a currency can be impacted by several variables. At the highest level, a country’s balance of payments—the net of all economic transactions between an individual country and the rest of the world—drives its exchange rates. In this case, a country’s competitive position on a global basis will determine the flow of goods and services. Productivity, investment opportunities, natural resources, education and skill levels, income trends, as well as the general level of prices (i.e. price stability or inflationary pressures) are all part of the mix. Surpluses or deficits in balance of payment items indirectly affect the supply and demand for a specific currency. In many cases this is not a direct relationship. For instance, it is possible to see a currency of a specific country that is running a trade surplus depreciate if capital outflows are significant and vice versa for a country running a trade deficit. In these cases, the balance of payments provides a rear view mirror of how a local economy has performed in the past. Investors, however, are focused on what the future movement in a currency will be. Expectations about future exchange rate movements are influenced by a lot more than just balance of payment conditions.

Central bank activity

On a real time basis, domestic bond market conditions and interest rates have a major impact on foreign exchange rates, often influenced by short-term capital flows. Central banks can intervene in the capital markets in a couple of ways that drive exchange rate dynamics. First, the impact of their purchases and sales of domestic currencies is no different than any other currency market participant (albeit sometimes at a greater size). Second, central bank activity or inactivity can help set current market expectations. The timing and size of central bank intervention, along with public comments made by monetary authorities may help reduce volatility or calm disorderly markets. In practice, central bank policies can be quite complicated when faced with achieving a variety of economic goals such as price stability, market liquidity, economic growth and borrowing rates which may be difficult to achieve simultaneously. As a result, exchange

rates reflect a countries’ economic experience, its relative competitiveness to attract capital flows and its political policies.

Commodity and the carry trade

Gold has reached record highs. (Fig. 3.) Investors are borrowing relatively inexpensive dollars

and investing in higher yielding currencies. Between the 1970s and early 1990s, gold prices and inflation trended more consistently than they do today. In the current environment, the link between a rise in gold prices and inflation is tenuous at best. Higher gold prices typically reflect fear, and in the current environment, as a currency substitute for a weaker dollar.

Moreover, currencies such as those of Brazil, Mexico and Peru that are more correlated with commodities have experienced relative appreciation. (Fig. 4.) The dollar’s weakness relative to these more natural resource-based economies makes sense at this stage of the global economic recovery.

Deficits and the dollar

China has repeatedly stated that it needs to diversify away from the dollar. With an explosion in

Treasury issuance to finance the U.S. budget deficit combined with a weaker dollar, rational

observers would suggest that China, other central banks, and Sovereign Investment Vehicles

(SIV) would shun investing in U.S. debt instruments. On the contrary, they have bought more over the past year. According, to the U.S. Treasury, foreigners bought almost half of the $1.4 trillion in Treasury securities issued this year compared with slightly less than 30% of the $500 billion during the same time frame in 2008. (Fig. 5.) And, for the record, China increased its purchase of Treasuries by 10% this year. (Fig. 6.) With almost $800 billion in Treasuries, China is still the dominant foreign borrower. This makes perfect sense as China has become accustomed to running trade surpluses

while keeping the Yuan benchmarked to the U.S. Dollar, its holdings of Treasuries increases as a result.

Moreover, there is no indication that foreign investors are dumping Treasuries in a meaningful manner. So despite, the news headlines that suggest our non-U.S. creditors are fleeing the dollar, foreign ownership of Treasuries has been rising steadily over the past three decades (Foreign holdings of U.S. Treasuries).

A disorderly dollar decline is simply not in China’s interests. With global economic conditions producing excess capacity and a glut of savings, few countries would want to see their currencies appreciate substantially. Instead, they would prefer to have a cheaper currency that maintains the competitiveness of their exports thus helping to thwart a dollar collapse. Today, even developed countries such as Japan and Canada are seeing exports slow as the value of their currencies relative to the dollar appreciates.

China is also not in a position to challenge the dollar as a reserve currency. China maintains exchange rate controls and lacks the developed financial system capable of serving as a reserve currency. The euro is the only serious challenger to the dollar’s status as reserve currency.

‘Dollar diversification’ has actually been occurring for about ten years now, as the dollar’s share of global reserves has declined from a peak of 72% in the early part of this decade to around 63% today. (Fig. 7.) The euro’s foreign reserve holdings have been steadily increasing relative to the dollar’s since the early part of this decade, from under 20% of total foreign exchange holdings to 28% today.

Interest rates

Another force behind the dollar’s relative weakness is extremely low short-term interest rates. With The Federal Reserve maintaining the Federal Funds rate at near zero, investors and speculators are encouraged to borrow inexpensively in dollars and buy other currencies, then invest the proceeds in higher-yielding securities.

If the dollar collapsed it might lead to accelerating import prices, which in turn would be viewed as inflationary, and may force the Fed to more quickly tighten monetary policy than it would otherwise like to do.

Where are we heading?

A much as Treasury Secretary Geithner and Federal Reserve Chairman Bernanke may talk about the importance of the dollar as the dominate reserve currency, they are less likely to intervene if the dollar’s decline continues to be orderly and eventually settles into a trading range. In fact, given benign inflation (and some deflation pressures still in the pipeline), excess capacity and a sub-potential growth outlook, a weak dollar in the short run may be helping drive exports and

promote economic expansion. With U.S. consumers and businesses deleveraging, an export-led

recovery may be a primary factor in sustaining GDP growth over the short to intermediate term.

When inflation becomes a concern, a stronger currency is more welcome. In the intermediate term, it’s possible the Fed may raise rates sometime in the second half of 2010. In this case, it would be to temper any inflationary pressure seen on the horizon as opposed to attempting to manipulate the dollar, but the end result may also have the effect of reversing the dollar’s downward trend.

In the long run, a weak dollar drives capital and jobs abroad which results in a lower standard of living. A stronger dollar would attract more capital, create more jobs, and ultimately increase our standard of living relative to other countries. Longer term, a persistently large trade deficit as well as ballooning fiscal deficits are threats to the dollar’s stability and, maybe even its viability as the world’s preferred reserve currency. The exploding national debt needs to be reined in. Economies can recover from high debt burdens with real growth and fiscal restraint, and the fiscal restraint component is particularly worrisome, given the high propensity to spend among the policy makers in Congress and the previous and current Administrations. Eventually, the U.S. needs to address its structural budget deficits to prevent future inflation, a devaluation of the dollar, and a potentially lower standard of living.